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Contributionto:JELClassification:K12TheNewPalgraveDictionaryofEconomicsandtheLawContractsStevenShavellAbstract:Theprivateandthesocialfunctionsofcontractsandofcontractlawareexaminedinthisentry.Insection1,onthebasictheoryofcontracts,thetopicsconsideredincludecontractformation,whycontractenforcementisvaluable,theincompletenessofcontracts,theinterpretationofcontracts,remediesforbreach,renegotiationofcontracts,andjudicialoverridingofcontracts.Insection2,theeconomicliteratureonproductioncontractsisreviewed,andinsection3othertypesofcontractarediscussed.2ContractsTheprivateandsocialfunctionsofcontractsandofcontractlawareexaminedhere.Insection1thebasictheoryofcontractsisconsidered,insection2productioncontractsareanalyzed,andinsection3severalothertypesofcontractarediscussed.1.BasicTheory1.1Definitionsandframeworkofanalysis.Acontractisaspecificationoftheactionsthatnamedpartiesaresupposedtotakeatvarioustimes,asafunctionoftheconditionsthatthenobtain.Theactionsusuallycomprisedeliveryofgoods,performanceofservices,andpaymentsofmoney,andtheconditionsincludeuncertaincontingencies,pastactionsofparties,andmessagessentbythem.Acontractissaidtobecompleteifthelistofconditionsonwhichtheactionsarebasedisexhaustive,thatis,ifthecontractprovidesexplicitlyforallpossibleconditions.Otherwise,acontractwillbereferredtoasincomplete.Typically,incompletecontractsdonotincludeconditionswhich,weretheyeasytoinclude,wouldallowbothpartiestobemadebetteroffinanexpectedsense.Itshouldbenotedthatanincompletecontractmaywellnothaveliteralgaps.Forexample,althoughacontractstatingmerelythataspecifiedpriceistobepaidforaquantityofwheatthatistobedeliveredisincomplete(itdoesnotmentionmanycontingenciesthatmightaffectthebuyerorthesellerofwheat),thecontracthasnogaps,foritstipulateswhatthepartiesaretodo(payaprice,deliverwheat)inallcircumstances.AcontractinsomerelevantclassoffeasiblecontractsiscalledParetoefficientifthecontractisimpossibletomodify(withintheclassofcontracts)soastoraisetheexpectedutility3ofbothofthepartiestoit;suchacontractwillsometimesbereferredtosimplyasefficientorasmutuallybeneficial.(Often,below,efficiencywillconnotetheefficienttermsintheclassofcompletecontracts,thatis,efficiencywillrefertoa“first-best”contract;thiswillbeclearfromcontextandshouldcausenoconfusion.)Contractsareassumedtobeenforcedbyatribunal,whichwillusuallybeinterpretedtobeastate-authorizedcourt,butitcouldalsobeanotherentity,suchasanarbitratororthedecisionmakingbodyofatradeassociationorareligiousgroup.(Reputationandothernon-legalfactorsmayalsoservetoenforcecontractsbutwillnotbediscussedhere;onsuchmechanismsofenforcement,see,forexample,Bernstein1992andCharny1990.)Enforcementreferstoactionstakenbythetribunalwhenpartiestothecontractdecidetocomebeforeit.Tribunalsmayimposemoneysanctions—so-calleddamages—forbreachofcontractorinsistonspecificperformanceofacontract—requirepartiestodowhatacontractspecifies(forexample,conveyland).Tribunalsmayalsofillgaps,settleambiguities,andoverridetermsincontracts.1.2Contractformation.Theformationofcontractsisofinterestinseveralrespects.Searcheffort.Partiesexpendeffortinfindingcontractingpartners,anditisapparentthattheirsearcheffortwillnotgenerallybesociallyoptimal.Ononehand,theymightnotsearchenough:becausethesurplusgainedwhenonepartylocatesacontractpartnerwouldordinarilybedividedbetweentheminbargaining,theprivatereturntosearchmaybelessthanthesocialreturn.Ontheotherhand,partiesmightsearchmorethanissociallydesirablebecauseofanegative(“commonpool”)externalityassociatedwithdiscoveryofacontractpartner:whenonepartyfindsandcontractswithasecond,otherpartiesaretherebypreventedfromcontractingwiththatparty.BothoftheseexternalitiesariseinDiamondandMaskin(1979),whoexaminea4specificmodelofsearchandcontracting.Althoughpoliciestopromoteortodiscouragesearchmightbedesirable,onewonderswhethersocialauthoritiescouldobtaintheinformationneededtodeterminethenatureofproblemswithsearcheffort.Mutualassentandlegalrecognitionofcontracts.Abasicquestionthatatribunalmustanswerisatwhatstageofinteractionsbetweenpartiesdoesacontractbecomelegallyrecognized,thatis,becomeenforceable.Thegenerallegalruleisthatcontractsarerecognizedifandonlyifbothpartiesgiveareasonablyclearindicationofassent,suchassigningtheirnamesonadocument.Thisruleobviouslyallowspartiestomakeenforceablecontractswhentheysodesire.Moreover,becausetherulerequiresmutualassent,itprotectspartiesagainstbecominglegallyobligatedagainsttheirwishes.Thus,itpreventstheformationofwhatmightbeundesirablecontracts,anditmeansthatsearchforcontractingpartnerswillnotbechilledduetotheriskofunwantedlegalobligations.However,certainlegaldoctrinessometimesresultinpartiesbecomingcontractuallyboundwithouthavinggiventheirassent:onepartymaybecomecontractuallyboundifthepartywithwhomheisnegotiatingmakesinvestmentsinanticipationofcontractformation.Thislegalpolicynotonlymayresultinundesirablecontracts,butalsomayinducewastefulearlyinvestmentasastrategytoachievecontractformation.Itistruethatearlyinvestmentissometimesefficient,butapartywhowantstomakeearlyinvestmentc